Global Imbalances

Financial Management MBA,

University of Coburg, December 2019
Alba Patozi

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Introduction: A set of questions
• Why do countries run current account deficits or surpluses?
• How long can external imbalances persist? Why are they the focus of
so much policy debate?
• How are nominal exchange rates determined?
• Why do countries default? What happens when they do?
• What are the determinants of risk premiums and how do risk
premiums affect macroeconomic outcomes such as output and
exchange rates?

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International Macroeconomics

is interested in:
• Prices: interest rates, exchange rates
• Quantities: current account, income, wealth…

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Outline
• Financial Globalization
• Global Imbalances
• National Income Accounting
• Twin deficits
• Balance of Payments Accounting
• NII-NIIP Paradox

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De facto measures of financial globalization:
flows and stocks
Flows: the value of gross asset trades for a given year: 𝛼!

Stocks: the cumulative value of gross assets held in a given year:

𝐴! = 𝐴!"# + α! = 𝐴!"$ + α!"# + 𝛼! =…. Stocks are the cumulative flows

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Stocks as a measure of financial globalization
Stocks: IFI (International Financial Integration) measure

𝐷𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑎𝑠𝑠𝑒𝑡𝑠 ℎ𝑒𝑙𝑑 𝑏𝑦 𝑓𝑜𝑟𝑒𝑖𝑔𝑛𝑒𝑟𝑠 + 𝐹𝑜𝑟𝑒𝑖𝑔𝑛 𝑎𝑠𝑠𝑒𝑡𝑠 ℎ𝑒𝑙𝑑 𝑏𝑦 𝑑𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑎𝑔𝑒𝑛𝑡𝑠

=
𝐷𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑐𝑜𝑢𝑛𝑡𝑟𝑦 ! 𝑠 𝐺𝐷𝑃

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International Financial Openness, 1970 -2004

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Two forms of globalization
• Real: Trade flows (Exports + Imports as a % of GDP)
• Financial: Financial flows (Gross Assets as a % of GDP)

Compare the two forms of globalization:

= Ratio of financial openness (financial assets) to real openness (goods)
= (Domestic assets held by foreigners + Foreign assets held by domestic
agents)/ (Exports + Imports)

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Trade and financial integration

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Comparison of industrialized countries share
in goods trade and financial trade

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What explains this trend in financial
globalization
• World capital markets were very integrated at the end of the 19th
century. Share of British wealth invested overseas: 17% in 1870 and
33% in 1913 (larger than any country today). Similar in France and
Germany.
• Capital outflows from UK (purchase of foreign assets) : mostly to the
New Worlds with natural resources: Canada + Australia (28%), US
(15%), Latin America (24%).
• What from: Portfolio investment (equity and bonds to invest in
railroads, harbors)

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The case for Financial Globalization?
• Washington Consensus: a collection of loosely articulated ideas in the
beginning of the 1990s aimed at modernizing, reforming,
deregulating and opening economies.
• These policies were believed to be necessary for the recovery of Latin
America after the financial crisis of the 1980s.
• Consequence: Many emerging markets opened up their capital
markets in the 90s (while most developed markets were already
opened)
• Why did governments promote financial integration so actively?

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Expected gains from financial integration
• Intertemporal gains: consumption smoothing in response to shocks or in
response to capital scarcity - small
• Intratemporal gains: international risk-sharing- still quite a debate on their
magnitude (large if you look at asset prices/small if you look at real
consumption)
• Growth effects: Financial integration can alleviate liquidity constraints and
facilitate long term investments
• The benefits in terms of domestic allocative efficiency: superior foreign
technology (FDI), market discipline on domestic policies, social
infrastructure, etc
• “The main potential positive role of international capital markets is to
discipline policymakers who might be tempted to exploit a captive
domestic capital market” (Obstfeld, 1998).

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Gains from financial integration? Empirics
• Cross country regressions using IMF- based measures look at the
impact of financial integration on growth
• Results range from no effect (Rodrik(1998)), to small significant effect
(Quinn (1997, 2008), Edwards (2001), Bekaert et al (2005)…)
• Stock market liberalization increases equity prices (Henry (2003) and
to a lesser extent investment and growth (Henry (2003), Bekaert et al
(2005))

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Global Imbalances
Refer to the large current account deficits and surpluses that have
emerged in the world economy.

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Global imbalances

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US Current Account Deterioration in Nominal Terms

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Global imbalances: Views
1) Trends in savings and investment
2) A US productivity surge
3) East Asian mercantilist behavior
4) The global Savings Glut
5) Distortions in Financial Markets

Source: The Evidence and Impact of Financial Globalization, (2013), vol.

3, pp. 67-79

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 How do we assess these views?
• Views 1 & 2 say that the world interest rate rises as the US savings fall.
• Views 3, 4& 5 say that the world interest rate falls as the foreign supply of
savings increases
⟹What happened to the real interest rate?

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The World Real Interest Rate: 1985- 2012

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Global Imbalances
• Stability of large capital inflows believed to be the greatest vulnerability to
the current system of global imbalances.
• Countries cannot borrow forever. How will external imbalances adjust?
Potential outcomes:
ØA benign adjustment: gradual reduction of CA surpluses in emerging Asia,
a gradual rise in real interest rates in the US.
ØA more abrupt and disorderly adjustment: abandonment of pegs in
emerging Asia, a decline in demand for US Assets, real depreciation of
the dollar, rising inflationary pressure requiring monetary tightening.

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National Income Accounting in an Open Economy
• National Income Accounting: records all the expenditures that
contribute to a country’s income and output
• GNP: value of all final goods and services produced by its factors of
production and sold on the market in a given time period; a measure
of national output
• In a closed economy: 𝑌 = 𝐶 + 𝐼 + 𝐺
ü Consumption (C): amount consumed by domestic residents
ü Investment (I): output used by firms to produce first output
ü Government consumption (G): government spending

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National Income Accounting
In an open economy:
𝑌 = 𝐶 + 𝐼 + 𝐺 + (𝐸𝑋 − 𝐼𝑀)
IM = value of imports (goods and services purchased from abroad)
EX = value of exports (goods and services sold abroad)

Current Account measures the size and direction of foreign borrowing. It is defined as:
𝐶𝐴 = 𝐸𝑋 − 𝐼𝑀
CA > 0 the country is lending to the rest of the world (accumulating foreign assets);
It is exporting present consumption and importing future consumption
CA < 0 the country is borrowing form abroad (accumulating foreign debt)
A country’s current account balance equals to the change in its net foreign wealth

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Gross Domestic Product
• Another measure of national economic activity is GDP: a value of
goods and services produced within a country’s borders
• GDP = GNP - factor of payments from foreign countries + factors of
payments to foreign countries

Example:
In 2006, the US’s income payments from foreigners: $666 billion,
income payments to foreigners $626 billion, so the net factor income is
$30 billion, so GNP = $ 13.277 trillion and GDP = $ 13.247 trillion in
2006.

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Current Account from the view of Savings and
Investment
• National Savings (S) = national income (Y) that is not spent on
consumption (C) or government purchases (G)
𝐶𝐴 = 𝑆 − 𝐼 = 𝑌 − 𝐶 − 𝐺 − 𝐼
• A current account deficit measures how much a country spends in
excess of income – or – how it saves too little relative to investment
needs- “living beyond its means”

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National Income Accounting
National saving = private + public saving

𝑌−𝐶−𝐺 = 𝑌−𝐶−𝑇 + 𝑇−𝐺

𝑆 = 𝑆 ! + 𝑆"

𝐶𝐴 = 𝑌 − 𝐶 + 𝐼 + 𝐺

𝐶𝐴 = 𝑌 − 𝐶 − 𝐺 − 𝐼 = 𝑆 − 𝐼
Where:
Current account = National saving – Investment = Net Foreign Investment
CA > 0 a country is saving more than it invests domestically
CA < 0 a country is investing more than it saves domestically 26
What causes CA deficits
A distinction between private and public savings

𝐶𝐴 = 𝑌 − 𝐶 − 𝐺 − 𝐼

𝐶𝐴 = 𝑌 − 𝐶 − 𝑇 + 𝑇 − 𝐺 − 𝐼

𝐶𝐴 = 𝑆 % − 𝑔𝑜𝑣𝑒𝑟𝑛𝑚𝑒𝑛𝑡 𝑑𝑒𝑓𝑖𝑐𝑡 − 𝐼

A high government deficit reduces the current account balance, all else
equal (“Twin Deficits”)
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 Case studies: Twin Deficits
Example 1:
• Reagan administration (1980s) slashed taxes and raised government
expenditure
• Generated large government deficit and current account deficit:
𝐶𝐴 = 𝑌 − 𝐶 − 𝑇 + 𝑇 − 𝐺 − 𝐼
• Hinges on the result that changes in government deficit does not change
private savings and investment behavior.
Example 2:
• In 1999, European governments cut government spending and raised taxes.
Current account did not increase. Why? Sharp fall in the private savings rate.

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Balance of Payments Accounting
• BOP records all the economic transactions in a specific time interval
between residents of a country and the rest of the world.
• Three types of transactions:
ü Involving goods and services: current account
ü Involving financial assets: financial account
ü Involving the transfer of wealth- capital account (normally non-market
activities, and often refers to the transactions of nonfinancial or intangible
assets)

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BOP identity
𝐶𝐴 + 𝐹𝐴 + 𝐾𝐴 = 0

• Transactions that involve a payment to foreigners (e.g. importing

goods or assets): debit (-)
• Transactions that involve a receipt from foreigners (e.g exporting
goods or assets): credit (+)

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Special Transaction in the Financial Account
• Official Reserve Transaction: purchase of sales of official reserve
assets by central banks
• Official Reserve Assets: foreign assets held by central banks
• Example: UK exports to Germany- credit in the current account.
• Bank of England exchanges the euros for pounds for the exporter.
Bank of England increases its reserve of foreign assets (Euros) – debit
in the financial account.

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 External Wealth
• The importance of external wealth
• NFA = Home Assets – Home Liabilities
• Home Assets: What is owed to the home country by the rest of the world;
Home Liabilities: What is owed to the rest of the world by Home.
• NFA also referred to as Net International Investment Position (NIIP) or net
foreign assets.
• NFA > 0: net creditor, NFA < 0: net debtor

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The Negative- NIIP- Positive- NII Paradox
• Suppose you have a negative balance on your credit card. Would you
expect to receive interest payments from your credit card company or to
have to make payments to your credit card company? Probably the latter.
• Well, that is not what happens with the United States. Look at the next
figure. Even though the US is the largest external debtor in the world, it
received investment income from the rest of the world.
• At the end of 2014, the US net international investment position stood at
$-7 trillion and its net investment income was $+0.25 trillion.
• How can this paradoxical situation happen? Here are two suggested
explanations: Dark Matter and Return Differentials. After the next figure,
we will spell them out.

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Positive Net Investment Income and Negative
NIIP: A Paradox

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What is plotted?
• Blue line: Net Investment Income (NII) which are income receipts on
US owned assets abroad minus income payments on foreign- owned
assets in the United States. [left scale, $bn]
• Red line: Net International Investment Position (NIIP), which
represents net foreign wealth of the United States. [right scale, $bn]
• Sample: 1976 to 2014

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 Explaining the NII- NIIP paradox: (1) Dark Matter

• The Dark Matter Hypothesis maintains that in reality the US international

investment position is positive, but that the Bureau of Economic Analysis fails to
account for all of it
• Assuming this theory is valid, how much dark matter is there in the NIIP? Let’s
make a simple calculation
üTNIP= the ‘true’ net international investment position
üNIIP = The observed net international investment position, $-7 trillion in 2014
üNII = The investment income, $0.25 trillion in 2014

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The Dark Matter Explanation
• NII is the return on the True Net International Investment Income
Position. So letting r denote the interest rate, we have
• NII = rTNIIP
• Let’s take the value of r to be 5% per year. Then solving for TNIIP we
have TNIIP = NII/r = 0.25/0.05 = 5 trillion dollars.
• Dark matter is simply the difference between the true and the
recorded NIIPs, or
• Dark Matter = TNIIP – NIIP = 5-(-7) = 12 trillion dollars!

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Dark Matter
• So, according to the dark-matter theory the US doesn’t owe $7 trillion
to the rest of the world. On the contrary, the rest of the world owes
$5 trillion to the US.
• Well, $12 trillion dollars of dark matter simply seems too big a
number to go unnoticed by the BEA!

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Explaining the NII- NIPP Paradox : Return Differential
• This second exploration is motivated by the observation that the gross
international asset position of the US is mostly composed of risky and high
return assets, such as foreign stocks, whereas its gross international liability
position is composed of safer low- return assets, such as T- bills.
• Let A denote the US asset position and L the international liability position.
Then NIIP = A –L. Let 𝑟 # be the return on A and 𝑟 $ be the return on L.
• The question is how large does the interest rate differential on assets and
liabilities have to be, to explain the paradox?
• Start by noting that the NII must equal the difference between investment
income and investment payments, that is
NII = 𝑟 # A − r % L

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Return Differential
• In 2014, the US gross international asset position was $25 trillion and its gross
international liability position was $32 trillion. In addition
$
the average real rate
of return on US T-bills which we will use as a proxy for 𝑟 , was very low, 0.13%
per year. Finally, as we mentioned earlier, NII was $0.25 trillion.
• Thus we set A =25, L= 32, NII = 0.25 and 𝑟 $ = 0.0013.
• We wish to find the value of 𝑟 # that solves the paradox. To this end, solve the
above equation for 𝑟 # .
𝑁𝐼𝐼 + 𝑟 $𝐿 0.25 + 0.0013𝑥32
#
𝑟 = = = 0.0117
𝐴 25

• That is 𝑟 # = 1.17% or any

#
interest
%
rate differential between the US foreign
assets and liabilities 𝑟 − r =1.04% per year. This doesn’t look like an
exorbitant premium .
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Return differential
• Why is it that a small interest rate differential suffices to explain the
NII- NIIP paradox?
• Because gross assets and liability positions have exploded in the past
30 years. They have roughly doubled every decade.
• Hence just a small rate of return differential can lead to positive NII
even though the NII is negative.

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Summary
• A country’s national income, GNP, must be used for consumption,
investment, government purchases and to run current account
imbalances
• In a closed economy, national savings must equal national
investment. In an open economy however, countries can borrow from
and lend to the rest of the world.
• Balance of payments accounts provide a detailed picture of the
composition and financing of the current account.

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